How to Sell a Business: Part 5
This is the fifth and final installment of a five-part series on selling your business.
How to Sell a Business: The Closing
Welcome to Part 5, the final installment of our five-part series this month on how to sell your business. In Part 1, I gave you an overview of the process. In Part 2, I described the process in more detail but focused primarily on planning for the sale. In Part 3, I discussed the valuation process – the sequence that professional business brokers go through to determine what a business will likely sell for. Part 4 was a discussion of marketing your business for sale and the all-important issue with getting the buyer financed. In this post we’ll consider some challenges you might encounter with the closing.
A NOTE: A thorough discussion of the closing process is beyond the scope of a single blog post, so I’m going to touch upon only a couple of the aspects. If you have specific questions, leave them in the “Comments” box at the bottom of this post. If you are interested in more detail, we are offering various courses teaching business brokering, one of which focuses on the closing process. You can learn more about that here. So, let’s get started.
Once you’ve got an executed contract with a buyer and financing for the purchase is lined up, there are still dozens of potential pitfalls and obstacles between you and the closing table and the longer the period of time between the contract signing and the closing, the greater the chance that the deal will fall apart. Let’s look at a couple of potential problems.
The Inventory Discrepancy
Whether your business manufactures widgets in three facilities in North America or sells premium wines and upscale kitchen tools and equipment from a storefront on Main Street, inventory is a big part of the sale and you have to know how to handle it. Most business owners have a good idea what their inventory is – and what is needed – on a day-to-day basis. An astute buyer will want a smooth transition. That means that enough inventory must be on hand so that the business can operate as if no transfer even occurred. (It is important to note that, for this discussion, when we are talking about inventory value, we’re talking about WHOLESALE value; what it cost you.)
The value of a business is based on its earning capability. In most cases, the business’ assets are needed to produce those earnings. As such, the assets needed to produce those earnings are generally included in the business’ valuation. The value of the inventory, however, is added to the business’ basic valuation. This is why you sometimes see businesses being offered at “$XX plus inventory”.
“But inventory fluctuates!”, you say. True. The seller should know the approximate wholesale value of the inventory and disclose that value in all marketing efforts to sell the business. As a general rule, the buyer – or by both parties – will want to have a complete inventory valuation done at the end of the process and the sale price is adjusted accordingly.
In many cases, the parties – particularly the buyer – will want a physical inventory done the day before closing. (There are firms that specialize in this task. If one is hired, the cost is usually split between the buyer and seller. If you need some contact information for such a firm, let me know in the Comments box at the end of this post.) But sometimes, a simple walk-through will satisfy the buyer. Let’s look at an example.
Using our Main Street business mentioned above, the business will generally have its customary level of inventory at the beginning of the sale process. Your marketing material (or the marketing package developed by the professional business broker that you, in your fathomless wisdom, hired to make this happen) will include an estimate of the value of the inventory that is customarily kept on hand; let’s say, $150,000. When the buyer first walks through the business, the buyer will get a sense of how much inventory equals $150,000 simply by looking as he or she does this first inspection. If the buyer walks through the day before closing and sees what seems to be approximately the same level of inventory, the buyer may not think that the cost and hassle of a physical inventory is warranted. However, if the buyer notices a significant visual change in the inventory level, he or she may put the brakes on the deal, demand a physical inventory and delay closing.
If a physical inventory is taken the day before closing and the result is at variance to the value of the inventory the seller stated was included in the sale price, that sale price is adjusted up or down to reflect that variance.
It’s rare but, over the years, we’ve had some less-then-upstanding business owners, in an unethical effort to put some additional cash in their pockets, sell down and not replace the inventory between the signing of the contract and the closing of the deal. Those deals rarely close because no one likes dealing with jerk; especially a jerk that is trying to cheat them. We, in fact, will no longer represent such a seller – and go after them for the commission.
As the seller, you want to disclose early on the approximate value of the inventory needed to run the business and maintain that level during the due diligence period and all the way to closing as if the business was not for sale; because, if you don’t, you will probably own your business a lot longer than you thought you would!
The Due Diligence Cop-Out.
It is almost universally true that the seller of a business undergoes a gradual but significant emotional and psychological metamorphosis between the signing of the contract to sell the business and the closing. Almost always the seller has mentally “sold” the business before closing and that mind set gets stronger and stronger as the closing date nears. Savvy buyers know this and many try to take advantage of it.
How? By coming to you a week or so before closing – while you are in the process of packing up your personal effects and planning to leave to spend a couple of weeks in the islands – and saying the they want to reduce the sales price by $50,000 because of this, this or that. The reasons are rarely justifiable (to the seller or, when it has happened during a deal we’re involved in, to us). Despicable buyers know that at this stage in the process, if they threaten to walk away from the deal, the seller is at his or her weakest point emotionally, may be too vested in the sale to counter this tactic and will likely agree to the reduction, albeit reluctantly and with no small amount of disdain for the buyer.
It is almost impossible to be emotionally prepared for this move. It has happened in deals we were involved in as brokers for the sellers and, though we warned the sellers that such a tactic was likely and tried to get them ready for it, they never are.
Notwithstanding the previous paragraphs, there are occasions when a buyer is justified in asking for a reduction in price. For instance, if the seller’s major client has just terminated a contract – or was itself sold – the dynamics of the deal may have changed significantly. And if the deal calls for the seller to stay on for a certain period of time as part of management or as a consultant, the buyer would be foolish to try to screw the seller in this manner, but it happens regularly.
So, what to do if you’re the seller? Well, the best defense against this tactic is to keep marketing the business even after a contract to buy it has been signed. (Make sure that the contract does not contain a clause that requires that you cease all marketing efforts.) Your ideal position is to have a backup offer – or at least several other very interested buyers. With a backup or other potential buyers, the hand you hold in your new negotiation with the buyer will be stronger as you try to work this out.
An additional tool to fight this with is a seeming willingness to delay closing so you can “consult with your advisors” or your spouse. If you seem to be willing to delay closing, you will give the impression that closing this deal is not critical to you and you may call the buyer’s bluff.
There’s an Option
No matter how much you try to prepare, in many cases – especially when closing is at hand – the seller has mentally left the business, is tired of the process and simply wants to be done and gone. But you don’t have to simply accept the buyer’s new price. If you have prepared yourself emotionally for the possibility that this could happen, you will at least be in a position to try to negotiate a “better” reduction. Even if the buyer’s request is justified, with the proper mental preparation ahead of time, you should be able to get the buyer to agree to lessen the reduction. After all, at this point in the process, the buyer has time, money and emotion invested in this deal, too.
If this happens in your deal, recognize that you will be unlikely to get the buyer up to the original contract price but, if you are prepared for this tactic and don’t lose your head when it is put in play, you should be able to reduce the haircut the buyer wants you to take.
One Final Thought on Preparation
Yes, you CAN prepare for this. If you were to hire a professional business broker to handle the sale, her or she would provide you with a business valuation that would identify what is the most probable selling price of the business (MPSP). Your broker would then suggest a listing price, generally higher than the MPSP by 10%-15%, an amount we call the “negotiating premium”. We do this because we know that most buyers, believing – not incorrectly – that everything can be bought for less than advertised, will offer an amount somewhat less than the asking price.
Your objective is to get as close to the MPSP as possible. You might consider using this same strategy – at least mentally – with the buyer when he or she wants to negotiate the “new” contract price before closing.
Let’s say that the business is valued at $950,000; the MPSP. The list price might be $1.1 million, roughly 15% above the MPSP. Through negotiations with the buyer, you agree to a purchase price of $925,000. But you, having read this post, anticipate the possibility that the buyer will, at the last minute, come back with a reason that the contract price should be lowered $60,000. You can prepare your response before this ever happens by identifying your bottom line.
If $875,000 is your absolute bottom line, below which you are willing to walk away from the deal, you are in a position to counter the buyer’s attempt to lower the price by offering to meet him or her at some point between the contract price and the lower price the buyer is now proposing – say, $900,000. You may still have to shave a bit more as negotiations continue but you are very likely to be successful in getting more than what is offered in this “new” negotiation phase – and more than your bottom line. But to be successful at this, you need to prepare far in advance. Start while the ink is still fresh on the contract!
There are many more aspects to closing the sale of a business, all of which are important but they are too numerous and complex to address in a single blog post. I’ll be tackling more of them in future posts so don’t forget to subscribe. But for now and for always, I suggest that you have a professional guide you through the process.
If you have questions or comments, put them in the Comments box, below. I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you next week.